Tuesday, April 9, 2013

Diamonds: Driven by market forces for the first time in 100 years

Up until recently the diamond industry had a structural flaw — just one player controlled it. De Beers was
the diamond industry, and diamonds were synonymous with De Beers.
However, over the last 25 years, a series of events led to the
dismantling of the De Beers monopoly. Today, De Beers no longer has
complete control of the diamond industry, and for the first time in a
century, market forces, not the De Beers monopoly, drive the diamond market.
In the late 1800s after a massive diamond discovery in South Africa, a
diamond rush was born, and businessman Cecil Rhodes bought as many
diamond mining claims as he could, including farmland owned by the De
Beer family. By the turn of the century, Rhodes had accumulated enough
properties that his company accounted for the majority of the world’s
supply of rough diamonds. He called his company De Beers Consolidated
Mines Limited.
As De Beers maintained a hold on the worlds rough diamond supply through the first quarter of the 20th
century, financer Ernest Oppenheimer began accumulating shares of De
Beers whenever available, and reached a controlling stake of the company
by the mid-1920s. Under Oppenheimer’s control, De Beers further
expanded into every facet of the diamond industry, intent on
monopolizing distribution. De Beers successfully influenced just about
all of the world’s rough suppliers to sell production through the De
Beers channel, gaining control of the global supply not produced by De
Beers mines. The cartel was born, giving Oppenheimer the power to
influence diamond supply and thus diamond prices.
The De Beers distribution channel, named the Central Selling
Organization or CSO, (later changed to Diamond Trading Co. or DTC), had
the power to sell what, when, and where they wanted to. In order to buy
from CSO, membership as a “Sightholder” was required, which was
completely the discretion of De Beers, as was the quality and price of
the product being sold. No negotiation between the CSO and Sightholder
occurred, all transactions were take-it-or-leave-it. In order to
maintain a stable but rising diamond price, De Beers had the power to
stockpile inventory in a weak market or raise the prices charged to
Sightholders, and then in an excessively strong price environment (with
the potential to damage demand), De Beers had the excess supply on hand
to release to the market when needed, repressing disorderly price
increases.
To keep the system intact, it was necessary for De Beers to maintain
control of the world’s rough diamond supply via purchases through CSO.
In the second half of the 20th century, as new world class
mines were discovered in Russia, Australia and Canada, it became more
and more difficult for De Beers to purchase all global production. The
biggest risk to the survival of the cartel was for mines to begin
selling directly to the market, thus bypassing De Beers.Source: WWW International Diamond Consultants Ltd, Economic Times of India, and Authors analysis.
Russia (present day the world’s largest diamond producer by value)
began producing diamonds in the mid-twentieth century. At first, the
Russians agreed to sell production to De Beers keeping the cartel
intact. However, this quickly became extremely costly to De Beers as
the Russian mines produced greater quantity and lower quality stones
than anticipated. This prompted De Beers to commence the ”Diamond is
forever” marketing campaign, transforming the image of diamonds to a
proxy for love, expanding demand of lower quality stones to a new middle
class American market, in an effort to absorb the new supply. Another
challenge emerged in 1963 when Anti-Apartheid legislation restrained the
Soviet Union from dealing with a South African company. But the final
blow to the arrangement came during the Soviet Union collapse in the
1990s, when political chaos and a weak ruble further separated Russia’s
production from De Beers.

Shortly after losing control of Russian supply, the Argyle Mine in
Australia, at the time the largest diamond producing mine in the world
by volume, broke away from the DeBeers supply chain. Over the next few
years, other mines followed suit, as new world-class mines in Canada
sold supply independent of De Beers.
The emergence of new supply distributed outside of CSO meant that De
Beers, was forced to hold back from selling large portions of its own
inventory and to purchase excess supply from its new competitors in the
open market, in an effort to maintain control of the market. By the end
of the 1990s, De Beers’s market share had fallen from as high as 90% in
the 1980s to less than 60%. De Beers no longer had control of the
market in 2000, when the company announced a shift in strategic
initiative to focus on independent marketing and branding, rather than
generic diamond price control.
However, the monopoly officially ended in 2001, when several lawsuits
were filed in U.S. courts alleging that De Beers “unlawfully
monopolized the supply of diamonds, conspired to fix, raise, and control
diamond prices, and issued false and misleading advertising.” After
multiple appeals, in 2012 the U.S. Supreme Court denied final petition
for review, and a settlement in the amount of $295 million with an
agreement to “refrain from engaging in certain conduct that violates
federal and state antitrust laws” was approved.Source: WWW International Diamond Consultants Ltd, Gem
Certification & Assurance Lab, Price Scope, and Authors analysis.
Price constitutes various qualities of rough and polished diamonds, and
shows diamond price deviation from starting basis of 100 beginning in
1987.
The way De Beers did business, which revolved around the central
concept of controlling supply in the market, was simply not viable in a
more competitive environment, and De Beers could not maintain the
monopoly. From 2000 to 2004 diamond prices modestly declined, as the De
Beers stockpile was liquidated into new demand coming out of Asia. By
2005, the inventory overhang had been lifted allowing market forces to
drive diamond prices for the first time in a century, resulting in
unprecedented price volatility. Diamond prices made a new high in 2007,
followed by a violent sell off in 2008 and 2009 before rebounding to
another new high in the summer of 2011.
With a market share of less than 40%, in 2011 the Oppenheimer family
announced a complete exit from De Beers, ending almost a century-long
ownership of perhaps the greatest monopoly in history.